What Is the Right 401(k) Contribution Rate?

The 401(k) Goal

For those who can afford it, the right 401(k) contribution rate is “the legal maximum.” Doing so will make for a fat retirement kitty.

However, as this year’s limit is $22,500 (or $30,000 for employees who have reached age 50), that strategy is unrealistic for most workers. They cannot set aside whatever the rules permit. They must instead compromise by saving what they can, with an eye toward what they eventually will need.

Today’s column addresses that topic, for those with typical incomes. (Friday’s installment will address higher-salaried employees.) Per the Bureau of Labor Statistics, the median annual wage for American workers is about $50,000 at age 25. Over the next decade, it increases to about $65,000, where it then remains for the next two decades, before declining slightly during the employee’s final years.

I used that wage-by-age scale for this article’s computations. Of course, inflation will increase future incomes, but I adjusted for that effect by making all calculations in real terms. To be sure, no worker’s earnings will precisely mimic those of the model, but precision is not necessary for the numbers to be relevant. Roughly speaking, its suggestions will serve any salary path that lands within the middle two quartiles.

The Model’s Assumptions

The model stipulates that employees will work until their 67th birthday and then retire. At that time, they will 1) file for Social Security and 2) begin withdrawing from their 401(k) accounts. This approach differs from the usual retirement-income plans, which specify retiring at age 65. But the full Social Security benefit does not arrive until two years later, and Social Security is an essential element of the projection. (Also, legislators expect future workers to retire at later ages.)

Other assumptions include 1) that Social Security will persist in its current form, 2) no additional income aside from Social Security and the 401(k) drawdown, and 3) the 401(k) portfolio permits a 4.5% annual inflation-adjusted withdrawal rate. The latter exceeds the 3.8% spending rate that Morningstar advocated last year for portfolios, but that advice was based on a younger retirement age. Also, that estimate was based on the conditions prevailing at the time, which were below the historic norm. In that light, using the higher 4.5% rate seems appropriate.

2 Income Targets

I tested two retirement-income targets: 1) annual spending equal to 80% of the employee’s income and 2) a lower target of 70%. These figures straddle the customary range prescribed by retirement providers. As Social Security replaces about 40% of the median worker’s income, the 401(k) portfolio must supply what remains: 40% of preretirement income for the higher target of 80%, and 30% of preretirement income for the lower target.

The table below summarizes the premises, along with the required 401(k) balances at retirement, to fund each goal. (Once again, these figures are shown in current dollars. The actual amounts will be much larger owing to inflation.)

Employee Assumptions (in Current $)

3 Investment Forecasts

Now for the portfolio returns. I invested the hypothetical 401(k) portfolios into a streamlined version of a target-date fund that holds 80% of its assets in equities from age 25 through 45, 75% in stocks over the next 10 years, and then 55% in equities until retirement. I did not incorporate fund expenses, which is somewhat unrealistic. On the other hand, the major target-date funds are becoming ever cheaper, plus the investor’s initial equity weighting is conservative. Call it a wash.

(That said, 401(k) participants who lack access to cheap funds will need to ratchet up the contribution-rate recommendations by 1-2 percentage points.)

I then modeled three investment possibilities.

Return Assumptions

(Average Annualized Real Return %)

The High scenario matches the historic results realized over the past century. Equities have gained 7.5% annually in real terms, and bonds have gained 2.3%. I saw no reason to adjust the fixed-income forecast, which lines up neatly with current real interest rates. However, few investment researchers believe that stocks will make 7.5% going forward, as equity prices have increased over the decade. I therefore created a Medium scenario with 5% real equity returns, which largely aligns with the expert consensus, and a Low scenario of 2.5%, should stocks disappoint.

With that preamble, here are the exercise’s results. Note that the required contribution rates include the consequence of company matches. For example, participants who contribute 4% annually with a 50% company match are credited with a 6% contribution rate.

Required Contribution Rates, Income Replacement 70%

(Annual Contribution Rate %, Including Company Match)

Required Contribution Rates, Income Replacement 80%

(Annual Contribution Rate %, Including Company Match)

3 Lessons

1) Age Matters!

This insight comes as no surprise, given that 401(k) seminars emphasize the importance of starting early, but then again, people who want your money tend to say such things. In this case, though, they are correct. Retiring with nothing but Social Security and 401(k) assets is a realistic goal for those who begin at age 25. Even poor investment returns permit median investors to receive 70% of their preretirement income with a 9.5% lifetime 401(k) contribution rate.

2) Performance Matters!

The difference between the blended lifetime rates for the High and Low return scenarios is but 3.7 percentage points per year, with the former earning an after-inflation 6.1% and the latter 2.4%. However, that seemingly modest disparity pushes the required contribution rate for the above example to 9.5% from 4%.

Naturally, the performance effect shrinks for employees who delay their 401(k) participation. By age 45, there’s little possibility of earning one’s way out of trouble. Even the High return scenario mandates a 15% contribution rate for 70% income replacement, and a 20% contribution rate to meet the higher 80% goal.

3) Discipline Matters!

On the surface, 401(k) participants appear to be in good shape. Vanguard reports that its customers have a median contribution rate of 10.6%, counting the effect of company match programs. In addition, three fourths of the company’s midsize to large plans have automated-default programs, with automated annual increases in contribution rates. In 80% of those cases, the automated increase feature does not cease until the employee contribution rate reaches at least 10%.

Those strategies should suffice for investors who begin at a reasonably young age, who steadily continue their contributions, and who do not withdraw early from their 401(k) portfolios. Those are very big ifs. Even at Vanguard, which has relatively high participation rates, one eligible 401(k) investor in five does not contribute. Many workers, particularly women, spend significant time outside the workforce during their careers. And half of Americans admit to having withdrawn early from a retirement account—albeit not always from a 401(k) plan.

Conclusion

The good news about 401(k) plans is that they can substitute for defined-benefit pensions. As illustrated by this article’s figures, starting a 401(k) plan at an early age, staying with the program, and following the prescriptions of the leading providers should provide for a comfortable retirement.

The bad news is that although compliance has increased over time, most American workers do not check all the boxes. They either lack 401(k) plans entirely (typically at smaller companies), or they participate irregularly. The theory is acceptable, but not always the practice.

As Friday’s column will illustrate, the case is somewhat the opposite with higher-income employees, who are likelier to contribute at steady, high rates to their 401(k) plans, but also possess sterner retirement-income goals. The contribution rates that suit median-income workers will not necessarily suffice for their wealthier counterparts.